Bulletin – March Quarter 2015
Market Making in Bond Markets

Abstract

In November 2014, the Committee on the Global Financial System (CGFS) published a
report on developments in market making and proprietary trading in fixed income
and related derivative markets (CGFS 2014). The aim of the report was to facilitate
a better understanding of how ongoing changes in these activities may affect
liquidity in markets and to assess whether these changes are driven by market
or regulatory forces. The report found that there have been changes in liquidity
conditions across markets, including in Australia, with market activity becoming
more concentrated in the most liquid instruments and declining in less liquid
ones. These changes in market-making activity have been driven by both market-based
developments and regulatory change. To the extent that liquidity risks were
underpriced in the period prior to the global financial crisis, many of the
subsequent changes in market structure and the increase in liquidity premiums
are welcome. However, with the changes still ongoing, bond issuers and investors
will be likely to have to make further adjustments to the way in which they
operate in fixed income markets and manage liquidity risks.

Introduction

Market makers are providers of liquidity in financial markets, serving as the intermediary
to facilitate transactions between buyers and sellers. In performing this role,
they contribute to the efficient functioning of financial markets, which is
critical for the allocation of capital in the economy. Changes in liquidity
conditions in these markets can have implications for the transmission of monetary
policy and financial stability.

The CGFS report on market making and proprietary trading provides a framework for
understanding the role of market makers as liquidity providers in fixed income
markets (CGFS 2014). The report outlines the trends and drivers of changes
in the supply of, and demand for, market-making services and the implications
of these changes for the functioning of markets. It draws on information from
all major financial markets, and was informed as well by interviews and an
informal survey of market participants. This article summarises the main observations
highlighted in CGFS (2014) and provides an Australian perspective.

Market Makers in Bond Markets

Most bond trading takes place in over-the-counter (OTC) markets rather than on exchanges.
One of the main reasons for this is that the large number of different bonds
issued means that there is only a small chance of finding matching orders to
buy or sell a particular security, unlike equity or currency markets where
products are more standardised. The role of matching demand and supply orders
is performed by market makers – typically the fixed income units of banks
and securities trading firms. These firms fill orders either by finding matching
orders or by acquiring the position themselves. If they do the former they
are acting like an agent or broker, whereas if they assume the position, they
are committing their own capital and taking on risk for which they expect to
earn an appropriate
return.[1]

Most countries have regulations defining market
making.[2]
A core element of these definitions is that market makers simultaneously quote
prices at which they are prepared to buy and sell securities (i.e. two-way
prices) on a regular basis. There are often more detailed contractual arrangements
between market makers and trading venues or issuers. Some countries (although
not Australia) restrict access to central government debt issuance markets
(primary markets) to primary dealers (PDs). PDs must meet specific requirements,
which include making markets in these securities. In return, PDs have preferential
access to debt auctions and other debt management operations. This arrangement
typically results in market makers competing strongly in secondary markets,
and in some cases these operations can be loss making. Other issuers may have
similar but less formal arrangements with market makers in order to ensure
that there is a sufficiently active secondary market. However, smaller issuers,
such as most corporations, are generally more concerned with ensuring that
they can issue in the primary market and typically do not make arrangements
to promote secondary market liquidity.

An operating model

There are a number of requirements to be a market maker in a bond market including:
capital and other types of funding; an appropriate risk management framework,
which, among other things, details the amount of risk that a market-making
desk can assume; access to hedging instruments; expertise in quoting prices
and managing financial risks in all market conditions; and a sufficiently large
client base. The market maker's interaction with the various internal units
and the market more generally is illustrated in Figure 1. A market maker generates
income from facilitating transactions and earning revenue on the inventory
of securities it holds.

Facilitation revenues are based on the difference between the price at a which a
market maker is prepared to buy a security and the price at which they are
prepared to sell that security (the bid-ask spread), net of the cost of transacting.
Transaction costs include trading fees (such as broker fees, custodial fees
and clearing costs) and funding, hedging and capital costs. A market maker's
bid-ask spread will be narrower, and quoted volumes larger, in markets where
they can offset the position quickly with a high degree of certainty and if
funding costs are low. During times of heightened volatility, the risk of a
given position increases and market makers tend to quote wider spreads, or
smaller quantities, in order to reflect this. A market maker's bid-ask
spread may also change in response to shifts in underlying factors, such as
market conditions in funding or hedging markets, internal governance arrangements,
capital costs, and their client base. Regulation and compliance costs will
also have an influence on these factors.

Revenue generated by holding inventory results from changes in the value of a position,
reflecting movements in the market price of the warehoused asset as well as
accrued interest. This revenue is offset by the cost of holding a position
in a security, including funding costs such as the cost of borrowing or lending
a security in a repurchase agreement and costs associated with hedging risks
in derivative markets.

In the past, many global banks ran large internal proprietary trading teams that
were closely tied to market-making teams. Market making and proprietary trading
activities may be distinguished by their different objectives. Market making
is based around providing a service to customers (for a fee) and the importance
of the client relationship. This means that intermediaries continue to provide
market-making services in less profitable markets or conditions. In contrast,
the objective of proprietary trading activities is to make profits for the
firm's own account. As such, they do not need to protect a client relationship
and are more likely to withdraw from markets if conditions are unlikely to
deliver a profit to them. Despite this distinction, the two activities may
appear fairly similar including in their risk profiles, particularly in less
liquid markets where market makers may hold positions for an extended period
of time.

Figure 1

Trends in Market Liquidity and Market Making

The CGFS report presented analysis of recent developments in market liquidity and
the demand for, and supply of, market-making services based on a variety of
metrics and feedback from market
participants.[3]

Market liquidity

The analysis confirms a picture of lower market liquidity in many bond markets during
crisis periods in the United States and Europe, followed by a recovery. This
is evident in many of the measures of market liquidity, including turnover
ratios and bid-ask spreads. Liquidity in sovereign bond markets, as measured
by turnover ratios, has now generally recovered to the levels seen prior to
the global financial crisis (Graph 1), unlike liquidity in many corporate
bond markets (Graph 2). Of note, the US corporate bond market, which is
the largest in the world, has seen a marked decline in its turnover ratio.
Feedback from many market participants emphasised a general theme of market
activity becoming more concentrated in more liquid instruments and deteriorating
in less liquid instruments.

Developments in Australian markets have been consistent with this picture, with liquidity
in the Commonwealth Government securities (CGS) market recovering more strongly
after the peak of the financial crisis than activity in the semi-government
or corporate bond
markets.[4]
Local dealers report that the CGS market remains highly competitive in comparison
to semi-government and corporate securities markets, where liquidity has generally
deteriorated. While there are several reasons for this, some market makers
indicate that the securities markets receiving lower levels of support from
market makers are those with a relatively undiversified or concentrated investor
base.[5]

Graph 1

Graph 2

In derivative markets, market makers in Australia suggest that activity has been
increasing in instruments that are centrally cleared, and falling in many bilateral
derivative markets that face higher capital charges and margin requirements.
A comparison of activity in interest rate swaps markets (which have been moving
to centrally cleared solutions) with cross-currency swap markets (which remain
bilateral) is consistent with this, with turnover in interest rate swaps above
pre-crisis levels and turnover in cross-currency swaps slightly below. The
cross-currency swap market is particularly important for the Australian financial
system and the Reserve Bank continues to monitor developments in this market
(see Arsov et al (2013)).

Supply-side developments

Market makers in many developed markets have changed their business models in the
past few years, effectively reducing the supply of market-making services.
This reduction is reflected in some metrics, including estimates of dealer
inventories and warehoused risk positions. These show a steep decline in inventories
held by US and European banks in the crisis years. Inventories remain below
their pre-crisis levels, in part because of the closure of several proprietary
trading desks. In contrast, there has been strong growth in inventory levels
held by emerging market banks. In Australia, an estimate of the aggregate level
of inventories has been broadly steady over this period, although there has
been a fall in the level of corporate bond inventories and in the share held
by foreign institutions (Graph 3). While some foreign market makers have
scaled back operations in some Australian markets, other foreign and local
participants have seen this as an opportunity to expand.

Graph 3

Feedback from market participants provides more detail on how market makers have
changed their business models. These changes have seen market makers allocate
less capital, risk and balance sheet capacity to market-making activities.
Market makers have focused their activities in core, often domestic, markets
and in less capital-intensive markets. Many are also tiering the level of service
they offer across clients to better reflect the cost of resources allocated
to the client. This has required a more granular assessment of the value of
a transaction, often on a per trade per client basis. Many participants are
also less willing to hold large inventory positions, particularly in illiquid
securities or derivatives. Market makers are turning over their inventory more
rapidly and operating more brokerage and order-driven business models. This
will be likely to result in dealers earning less from inventory revenues than
they have in the past.

One feature of this change highlighted by many Australian market makers is that the
liquidity offered by a market maker is now more dependent on its client base
than its risk warehousing capacity. As a result, there has been a general move
by market makers to broaden their client bases and enhance their connectivity.
This has contributed to growth in the use of electronic trading platforms in
many bond markets, although overall use of these platforms remains low compared
with foreign exchange and equity markets. Part of the reason is that the electronic
platforms are only used for a limited range of standardised and smaller-sized
transactions. However, multi-dealer electronic trading platforms generally
improve price transparency and competition by allowing market participants
to access pools of liquidity. This competition can lower the cost of transacting
in a security. Furthermore, the move toward greater electronic trading enables
market makers to lower the cost of providing their services, potentially offsetting
the need to earn greater returns through, for instance, wider bid-ask spreads.

Demand-side developments

In contrast to the fall in supply of market-making services, the demand for such
services appears to have been rising. This is particularly evident in countries
where there has been a rapid expansion in the size of their government and
non-government bond markets, and is the case in Australia. Globally, much of
the increased issuance has been absorbed by investment funds, which offer investors
daily liquidity and depend to at least some degree on market liquidity to fulfil
this commitment. The CGFS report also highlighted that the increasing concentration
of global bond market assets under management would bring greater sensitivity
of market liquidity conditions to investment decisions of these market players
(CGFS 2014).

Some asset managers have reduced their demand for market-making services by adopting
more medium-term portfolio management strategies that require less turnover.
These strategies include adjusting their portfolio composition to reflect changing
liquidity risks, becoming more opportunistic in the timing of trades and seeking
to facilitate trades by leveraging inventory data provided by market makers.
Furthermore, longer-term investors, such as pension funds and life insurers,
remain well positioned in many markets to mitigate the effects of reduced market-making
capacity. This reflects the fact that increased volatility may provide these
investors with more opportunities to take advantage of mispriced deals. However,
it is likely that not all asset managers have adjusted their portfolio allocations
or modified their internal liquidity risk management strategies to take account
of the reduced market liquidity and changing market structure.

Market and Regulatory Drivers of Change in Market Making

The financial crisis revealed that liquidity risks had been underpriced. Also, funding
models for many market makers proved vulnerable to changes in market liquidity
conditions and capital requirements for many trading activities were insufficient
to absorb losses. The next section discusses how the change in supply of market-making
services reflects the reaction of market makers to developments in markets
and new regulatory standards.

Market drivers

According to feedback from market participants, a reassessment of the risk-return
trade-off as a result of market turbulence during the financial crisis has
been a key driver of the decline in the provision of market-making services.
This reassessment of risk has seen dealers seek higher returns from operating
in some markets, reflecting increased funding costs and a desire to earn a
higher and more stable return on equity. The focus on generating an appropriate
return has come from shareholders, creditors and internal management. Where
returns are insufficient to compensate for the risk incurred, banks have scaled
back their activity.

One of the key ways in which market forces weighed on market-making capacity was
through a rise in funding costs. This rise contributed to a weakening in the
relationship between many derivative and physical markets and a deterioration
in the effectiveness of hedging strategies. This led many banks to reassess
the size of the positions they could hold. For instance, market makers continue
to show a greater reluctance to sell bonds that are difficult or costly to
source, such as those issued by supranationals and corporations. Another constraint
on market makers' capacity to operate is their ability to hedge or net
off positions through other markets. The decline in liquidity in some derivatives
markets, and certain credit default swap (CDS) markets in particular, affected
the ability of dealers to redistribute risks, further increasing the cost of
warehousing positions.

For some banks, the reassessment of risk has resulted in an overall reduction in
risk tolerance through tighter risk limits. This is likely to have been the
case for some European and US banks, including their operations in Australia.
These institutions have scaled back their operations through smaller capital
and balance sheet allocations, tighter and more binding value-at-risk
(VaR)[6]
limits and increased charges for holding inventory. However, even for banks
that have not reduced risk limits, the focus on generating an appropriate return
from market-making activities has seen their tolerance for warehousing risk
reduced if a return hurdle is not achieved. As indicated above, many banks
are focusing on assessing the return from each trade or from each customer
to ensure a market-making business is generating an appropriate return on equity.
The data on bid-ask spreads show that market makers have generally been unable
to generate wider spreads (at least for small volumes), and instead have reduced
or rationed levels of activity (see CGFS (2014, Section 3.1)).

Regulation

Just as banks have adjusted their exposures to market risks through their market-making
businesses, regulators have initiated a range of reforms to improve the robustness
of the financial system. Table 1 outlines how various regulations are likely
to affect market-making activities, based on information gathered from feedback
with market participants.

Table 1: International Market Participants' Feedback on the Impact of Regulatory
Reforms(a)

(a) Summary of feedback from interviews conducted with the private sector
(b) Only lists the regulation's expected primary impact on market makers'
profit and loss statement – that is, does not account for changes
in general cost factors (e.g. compliance, IT infrastructure investment)
or feedback effects (e.g. reduced leverage could lower banks' funding
costs by reducing the risk of default)
(c) These include US rules for swap execution facilities and EU rules for markets
in financial instruments Source: CGFS (2014)

Participants in the CGFS survey were also asked about the impact of the regulatory
reforms on their overall profit from market-making activities, inventory levels,
facilitation activities and hedging activities. The survey indicated an expectation
that there would be a moderate decline in overall market-making activity as
a result of regulations.

There was significant variation in responses across countries and markets. The impact
of regulations on market makers in developed markets was expected to be larger
than on those in emerging markets. In Australia, the impact appears to lie
in between these two groups. This may reflect the fact that Australian banks
do not have large trading operations in comparison to some US and European
banks, so there is less scope for them to be affected. On the other hand, a
significant proportion of market-making services in Australia are supplied
by foreign banks, which have faced greater pressures from some regulations.
Furthermore, Australian financial markets are more integrated into global capital
markets than many emerging markets, meaning that changes in conditions in overseas
markets are more likely to be transmitted into domestic markets.

The responses to the CGFS survey are summarised below.

Leverage ratio: Survey respondents indicated that the leverage ratio, which
limits the build-up of excessive leverage in the banking system, would have
the largest impact on their fixed income business. This was also true in Australia,
although the size of the impact was expected to be much smaller with Australian
banks indicating that the impact would be moderate whereas some foreign banks
with operations in Australia indicated that the impact on them would be significant.

Capital requirements: More stringent capital requirements were seen as having
a moderate impact on market-making activity overall but with a more pronounced
impact on inventory levels of more risky assets and derivatives. A similar
impact is expected in Australia and this is consistent with the reduction
in inventory levels of riskier securities such as corporate bonds and some
derivatives.

OTC derivatives reforms: Mandatory clearing of standardised OTC derivatives
was expected to have a limited impact on market-making activity. Some banks
indicated that these reforms would have a mildly positive effect on facilitation
and hedging activities because banks faced reduced costs from operating in
these markets. Regulations on margin requirements for non-centrally cleared
derivatives were expected to have a moderately negative impact on overall
market-making activity and have caused some pricing fragmentation.

Liquidity regulations: The impact of these regulations is seen to be modest
for most banks, although more complicated in Australia due to the limited
supply of high-quality liquid assets (HQLA) and the introduction of a committed
liquidity facility. Banks noted that the effect of these regulations was for
banks to hold higher levels of HQLA in their home jurisdictions.

Proprietary trading: Whereas around half of global respondents indicated a
moderate impact on market-making activity from regulations restricting proprietary
trading, Australian banks indicated that there would be very little impact.
Since the financial crisis, some regulatory effort has gone into distinguishing
market making from proprietary trading in order to limit the amount of proprietary
trading undertaken by banks. Large proprietary trading desks have not been
a feature of the Australian dealer market for some time, with a few ceasing
operations in the past few years.

Participants were also asked to indicate how much progress they had made in adjusting
their market-making business to the various regulatory reforms. Reflecting
the different pace at which regulatory reforms are being implemented in different
jurisdictions and differences in the amount of adjustment required by banks
across jurisdictions, there is some variation in the progress Australian banks
have made compared with that of overseas banks. For instance, liquidity coverage
ratio arrangements came into effect on 1 January 2015 in Australia, ahead of
the United Kingdom, United States and many European countries, although some
banks in these jurisdictions are also already compliant. Fewer banks globally
and in Australia have fully adjusted their businesses to the leverage ratio,
which banks are required to disclose this year but only fully comply with from
2018. However, some global banks have made significant adjustments in order
to comply with this measure by the disclosure date whereas most Australian
banks indicated that less adjustment was necessary. Meanwhile, most banks have
made progress in adjusting to the new risk-weighted capital requirements and
proprietary trading rules, and at least some progress in moving to mandatory
clearing arrangements. Most global and Australian banks indicted that there
is more work to do to adjust to the rules on margin requirements. Overall,
this indicates that there may be further effects on market-marking businesses
from the new regulations.

Market Implications

Cost of transacting and issuing debt

A steady increase in demand for market-making services and flat or falling supply
could cause both trading costs to rise and market liquidity to fall. The evidence
compiled in the CGFS report suggests that there has not been a widespread increase
in the cost of trading, although there have been at least some changes in market
liquidity across instruments (CGFS 2014). It is likely that there has been
an increase in the time taken to trade large amounts, particularly in less
liquid instruments. There has also been some rationing in the supply of market
making across customers. In some markets, the rise in trading costs has been
constrained by the level of competition among market makers and lower operating
costs that have been achieved through rationalisation of business models and
greater use of electronic platforms. In Australia, for instance, CGS and centrally
cleared derivatives markets have remained more competitive than some other
bond and non-centrally cleared derivatives markets. Unlike the CGS market,
where market-making capacity lost through the withdrawal of some players has
been replaced by the entry or expansion of others, the corporate bond market
has seen an overall decline in market-making capacity and an increase in transaction
costs. The CGFS report also notes that the current stance of monetary policy
in some jurisdictions is contributing to compressed liquidity premiums and
is likely to be delaying some of the adjustments that could be made (CGFS 2014).
As such, greater trading costs may only be revealed as monetary policy is normalised
in some countries.

Higher liquidity costs could result in bond issuers, particularly corporate issuers,
paying a higher liquidity premium at issuance. In Australia, credit spreads
have compressed sharply over the past few years (though they remain above pre-crisis
levels), mainly reflecting the repricing of credit and liquidity risk. In response,
corporate issuers could structure issuance to enhance the liquidity of their
securities by, for example, reopening lines of issuance rather than creating
bespoke (i.e. non-standardised) securities to limit the number of distinct
securities. They could also standardise maturity dates to align them with derivative
expiry dates (though this could accentuate cash flow mismatches for the issuer).
However, there is little evidence that corporate issuers have made any significant
adjustments beyond making greater efforts to sell securities to ‘buy-and-hold’
investors that do not value secondary market liquidity.

Market robustness

A likely implication of a reduction in the supply of market-making services is that
many markets are less liquid and more volatile, on average. To the extent that
market liquidity was previously oversupplied and incorrectly priced, this is
a desirable outcome. Furthermore, while both market and regulatory forces have
driven change, it was the intention of many regulations to reduce the risk
of systemic stress by limiting the extent to which banks could be a source
of contagion in markets. That is, in order for the markets to be more robust
many banks need to play a different role.

While these developments should decrease the likelihood that banks will be a source
of contagion in times of stress, it also means that banks are less likely to
cushion large order imbalances that may cause market
volatility.[7]
The role of absorbing these imbalances may therefore be taken on by other market
participants. In effect, therefore, limits on the amount of risk that banks
can or are willing to absorb has resulted in a transfer of liquidity and market
risks to investors. Nevertheless, many of these investors are better placed
to manage these risks because they are less sensitive to short-term price movements
than banks.

That said, many markets and market participants are still adapting to the structural
changes. For instance, the CGFS report noted that there is little overall evidence
that asset managers and other institutional investors have raised their liquidity
buffers or altered the redemption terms of their funds to better reflect their
liquidity risks (CGFS 2014). A consequence of this is that funds that rely
heavily on market liquidity (such as those that make explicit or implicit promises
of daily liquidity) may contribute to a stressed market sell-off, rather than
dampen it. The CGFS report also outlined other factors that could increase
the probability of an order imbalance, including:

the compression of liquidity premiums to very low levels in many markets, comparable
to those prevailing prior to the crisis and insufficient to compensate for
the risks

a reduction in the diversification of bondholders through an increase in the
market share of large asset managers and greater correlation among investment
strategies

the increased concentration (and therefore less diversification) in the supply
of market-making services in many markets.

Ongoing Developments

In emphasising that the markets are still undergoing a process of change, the CGFS
report outlined a number of initiatives that should support more robust market
liquidity conditions. Initiatives that market participants or industry bodies
could adopt (supported by the relevant authorities) include:

improving the transparency and monitoring of market-making capacity and market
liquidity with a view to keeping track of the impact of regulatory and other
structural changes

improving liquidity risk management by other market participants such as managed
and pension funds, and financial and non-financial corporations to ensure
that their risk management frameworks account for the transfer of liquidity
risk

supporting the robustness of hedging and funding markets through, for example,
the use of central counterparties or tri-party repo

ensuring that market makers are resilient and can withstand stressed market
conditions, and that capacity is not overly concentrated

improving market-making arrangements by expanding incentive schemes for market
makers and through greater standardisation of debt securities by less frequent
non-sovereign issuers.

One of the most important issues for Australia is the transfer of liquidity risk
from market makers to other investors. This is likely to result in increased
volatility, although the current stance of monetary policy in major regions
may be dampening this change. Nevertheless, liquidity risk management presents
an ongoing challenge for market participants, particularly for managed and
superannuation funds.

Another issue of importance for Australia is the cost of transacting in and access
to non-centrally cleared derivatives markets, such as the cross-currency swap
market. This has important implications for the financial and non-financial
sectors that seek to hedge risks using these instruments. One element of controlling
the costs of transacting in these instruments and improving market liquidity
may be finding a centrally cleared solution for them. Work on this front is
ongoing (see CFR (2014)).

Footnotes

The author is from Domestic Markets Department. The author would also like to acknowledge
the valuable input to this article from a number of colleagues and market
participants, and in particular
Kateryna Kopyl.
[*]

Typically, market makers look to hedge most of the credit and market risks from the
positions acquired. Acquired positions may also partially or fully offset
another position on their books.
[1]

In Australia, a market maker is defined in the Corporations Act 2001. For other countries, see Appendix 2 in the
CGFS report (CGFS 2014).
[2]

See Lien and Zurawski (2012) for a discussion of developments in the bond futures
market.
[4]

See Debelle (2014) for a discussion of developments in the investor base of the Australian
bond market.
[5]

Value at risk (VaR) is a measure of the level of risk that is tolerated and can be
expressed at a firm or trading desk level. If a trading bank has a VaR limit
of $1 million with a confidence level of
5 per cent then it expects to lose $1 million or more once every 20 days.
[6]

Analysis of dealer positioning and market liquidity in times of stress revealed that
US dealers contributed to the bond market sell-off in May 2013 through a
reduction in inventories. The analysis concluded that the reduction in inventories
was caused by internal risk preferences, not regulatory constraints.
[7]